How to Get the Balance Right: Fiscal Policy At a Time of Crisis

Last autumn was a turbulent time for Europe. The debt crisis deepened and financial markets became embroiled in turmoil, driven by fears of widespread restructuring of public debt. The crisis has harmed growth, increased unemployment, and left a large number of people less protected.

We are now seeing some signs of stabilization. Most countries are reducing their deficits and even if debt ratios are still rising, the return back to fiscal health has begun.

The International Monetary Fund and the Swedish Ministry of Finance are hosting an international conference in Stockholm on May 7-8, with the purpose of sharing knowledge and providing guidance on the best way to achieve fiscal consolidation, and on the role that effective fiscal policy frameworks and institutions can play in this endeavor.

Learning from experience

Sweden provides an interesting case study for countries’ current predicament. In the early 1990s, Sweden was rocked by an economic crisis with escalating unemployment, double digit deficits, and a sudden loss of market confidence that raised the cost of sovereign borrowing.

In response, Sweden initiated a comprehensive set of reforms. Favorable external conditions helped, but domestic policies played a critical role in the adjustment. Strong fiscal tightening was implemented to regain fiscal sustainability and market confidence. This was accompanied by the effective handling of the crisis in the financial sector, and structural reforms that raised Sweden’s competitiveness, long-term growth rates, and real wages. A new fiscal policy framework—founded on a surplus target, a medium-term expenditure ceiling and a comprehensive top-down budget process—has since helped preserve strong public finances and prepared Sweden well for the current crisis.

The experience of other countries—both those staring into the headlights of a crisis and those more gradually realigning their economies to a sustainable position—can also provide valuable lessons for those now struggling with large debt, persistent deficits, sluggish economic growth, and a lack of market confidence. While recognizing that the current crisis is unique in its scope and scale, three broad lessons can be learned.

Developing a medium-term plan

First, a comprehensive and clear plan for restoring the health of public finances needs to be developed and adopted at the outset, although consolidation measures can be spread over time depending on country circumstances (countries that are feeling more pressure from financial markets would have to frontload the adjustment; others would have more time).

Countries that have succeeded in bringing down public debt from high levels, such as Canada during the 1990s, followed this approach. It is particularly important to be clear in areas where policy decisions are hard. In the current circumstances, fiscal credibility can be significantly enhanced by clarifying how the severe long-term challenges from rising aging-related (pensions and health care) spending will be addressed.

IMF staff project this spending to increase by an average of 4 percentage points of GDP in advanced countries over the next two decades. This trend cannot be ignored. At the same time, fiscal adjustment should be done in a way that protects the poor and most vulnerable, and shares the burden across the population. If painful fiscal reforms are not perceived as fair, they never gain the support of citizens.

Having a strong institutional framework matters

Second, well-designed fiscal institutions can support the implementation of fiscal plans. The importance of strong budgetary institutions—the set of rules and procedures defining the preparation, approval and execution of the budget—cannot be underestimated. Here too a medium-term orientation is important, particularly when it comes to public spending.

In countries like the Netherlands and Finland, fiscal policy has been driven for years by well-designed medium-term expenditure frameworks. Of course, introducing fiscal frameworks on paper is not enough. An equally important aspect is transparency, which allows plans to be scrutinized and ensures that governments can be held accountable for their implementation. In this area, Australia and New Zealand have been leading with their codified transparency requirements. Independent fiscal councils can also play a role.

Reforms to support growth

Third, fiscal adjustment should go hand-in-hand with structural reforms that lay the foundation for sustained productivity and employment growth. Growth will alleviate the daunting challenges of fiscal consolidation, and the task is to find ways of encouraging it without undermining the fiscal position. Reforms in product and labor markets—several countries in Europe are stepping up their efforts in this area—may not yield immediate results, but will over time boost economic growth and lighten the burden of fiscal adjustment. IMF calculations suggest that increasing annual productivity growth by just a quarter of a percentage point could generate a virtuous circle leading to a decline in the public debt ratio of six percentage points within 10 years.

The way forward will be difficult. The fiscal challenges are daunting. It is easy to feel discouraged. But experience shows that rapid improvements are possible.

There is a way forward, but it requires immediate and resolute action on numerous fronts. The Stockholm conference is a small but important contribution to these efforts.

Anders Borg is the Minister of Finance for Sweden. He was appointed after elections in 2006. Mr Borg studied philosophy, economic history and political science at Uppsala University and took postgraduate studies in economics at Stockholm University.

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8 Comments

And Anders, I hope you take the opportunity to remind those there present in Stockholm that in your Swedish churches, for very good reasons, you pray “Gud gör oss djärva!”, “God make us daring!”; and that you should ask your bank regulators in Europe, to immediately stop discriminating against the small businesses and entrepreneurs with their silly capital requirements for banks, only because they are perceived as “risky”… something for which they are already discriminated against by the markets and the bankers.

The small businesses and entrepreneurs are the sparkplugs of the engine of economic growth, which is unfortunately something the central bankers, those now seemingly taking over the growth agenda, have naturally not the faintest idea of.

—‘ the set of rules and procedures defining the preparation, approval, and execution of the budget cannot be underestimated’ correctly advised by two experts like Anders and Christine Lagarde.

Without traffic wardens, traffic cannot be controlled on the road. Likewise effective regulations and regulators are needed for smooth running of the financial institutions. Per Kurowski’s repeated insistence on deeper involvement of the private and retail sectors will promote economic growth and will also cause reduction of sovereign risk.

Javed Mir, since you mention “traffic” let me use that to explain in some other words part of what has happened.

The credit ratings are like traffic lights, indicating green, yellow and red, and the banks and the markets observe these and take their precautions.

But then came the bank regulators and with their capital requirements ordered the banks to drive much much faster when the light was green, and so, when there suddenly was a technical failure, as should have been expected with human fallible credit rating agencies, and the light that should have been red was green… we had the mother of all crashes.

Bank regulators completely forgot that their role is not to trust the traffic signs, credit ratings or risk models, but to prepare for if something goes wrong with these.

[…] Joe Stiglitz is talking about in the post below this one. The IMF embraces the confidence fairy: How to Get the Balance Right: Fiscal Policy At a Time of Crisis, by Anders Borg a…: Last autumn was a turbulent time for Europe. The debt crisis deepened and financial markets became […]

What?? Sweden recovered thanks to the abolition of the fixed exchange rate and a massive depreciation of the Krona. This is what passes for economic analysis? It’s like watching a train wreck in slow motion…

An important way to bring momentum in economic growth is through policies that rid the economy of barriers to more efficient use of capital and labor. For this, product and labor markets must be more flexible. In addition, the regulatory system should be designed so that it encourages production and weakens the interplay of economic dynamics as little as possible.

Fiscal consolidation needs to be spread over a longer time period, otherwise there is the risk that cutting government spending too quickly can prolong the recession.

A country that wants to prolong its fiscal consolidation, however, must move forward in return by liberalizing their labor markets and reforming its pension systems.